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Can Ally Financial Pull Off an AIG-Style Turnaround?

Ally Financial (NYSE: ALLY) has returned to the capital markets in the second quarter of 2014. Though the auto finance company may not immediately be able to woo investors who are still put off by the company's financial history, its $17.2 billion bailout and low profitability, Ally Financial has great potential to increase earnings and valuation multiples once the government has completely divested of its remaining equity stake.

The finance company, General Motors' former finance arm known as GMAC, specializes in auto financing and leasing and can be expected to do reasonably well in an environment of higher interest rates and higher economic growth. Higher demand for auto loans should also be supported by higher disposable incomes and consumer spending in the years ahead.

More importantly, there might actually be significant parallels to the American International Group (NYSE: AIG) turnaround story.

Parallels to AIGSimilar to Ally Financial, American International Group received a massive bailout during the financial crisis. The bailout itself as well as sensationalist headlines, which pretty much stigmatized the insurance company as a failure, contributed to the tarnished reputation from which American International Group continues to suffer until this day.

Ally Financial is no different here. The much publicized bailout certainly hurt its reputation and low short-term profitability is not likely to attract investors. But that is likely to change and investors who excel in displaying patience might be very well rewarded.

Though hated by investors, American International Group has bounced back strongly, repaid the bailout funds and now focuses on growth. When the government divested of its stake in the early $30s, investors were just starting to warm up about the insurance company. AIG now quotes at $55.

And I have every reason to believe Ally Financial will be able to pull off a similar turnaround story, especially when investors start seeking investments with higher earnings yields and gravitate toward higher risk asset classes once again.

Government divestmentAlly Financial has made great progress in paying off the U.S. Treasury. The company pursued an IPO in April 2014 at $25 per share, which allowed the Treasury to collect another $2.4 billion in IPO proceeds.

Including the IPO proceeds from the second quarter, Ally Financial has actually returned $17.7 billion to the government including a $500 million profit. The government has previously extended $17.2 billion as part of its Troubled Asset Relief Program (TARP) in order to keep Ally Financial afloat during the financial crisis.

Though Ally Financial has repaid the bailout funds, the U.S. Treasury continues to have a stake in the auto finance compan,y which I expect will be sold down throughout the remainder of the year and 2015.

Source: Ally Financial Investor 1Q Earnings Review Presentation

Similar to American International Group, I expect much more investor interest in Ally Financial once the government has divested its stake in the auto finance company.

Having the government as a shareholder accomplishes two things: It can stabilize the company in a time of distress and loss of investor confidence, but it can also limit growth opportunities as a result of restrictions that are levied upon the company, for instance in terms of management compensation limits.

Return targetsAlly Financial exhibited fairly low returns on equity over 2013, but the company is in the process of improving operations and has communicated its ambition to achieve a double-digit core return on tangible common equity (ROTCE).

Ally Financial's core ROTCE stood at 6.5% in the first quarter of 2014 and has already meaningfully improved compared to the low 2-3% range it reported in 2013.

Moreover, Ally Financial has made significant progress in pushing down its efficiency ratio and improved its capital position, too.

Source: Morgan Stanley Financials Conference June 11, 2014

Should the company indeed achieve higher equity returns driven by revenue growth, cost savings and efficiency improvements, its valuation could experience significant tailwinds, especially when the government is out of the picture.

ValuationCompared against American International Group as well as Bank of America (NYSE: BAC) , Ally Financial actually compares quite well with a P/B multiple of 0.87.

However, this should not cloud the view on the big picture: The book value multiple is still low and has substantial potential to expand if Ally Financial continues to grow its asset base and return targets are met.

The Foolish Bottom LineAlly Financial could pull off a similarly impressive turnaround as American International Group. The financial crisis pushed the finance company out of the picture for a while as the company went through a tough restructuring. But Ally Financial is back and it is still cheap.

For investors with patience and no short-term obsession over any particular quarter, Ally Financial might just be a great turnaround stock with an asymmetric payoff profile.

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Kingkarn Amjaroen owns shares of American International Group and Bank of America. The Motley Fool recommends American International Group and Bank of America. The Motley Fool owns shares of American International Group and Bank of America and has the following options: long January 2016 $30 calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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